Quantifying ESG Investments can be daunting. As compared to private Impact investments, an allocation of capital by which investors can often see a quantifiable amount of impact created (increased water infrastructure, new jobs, etc.) as the result of each dollar invested, public ESG investment dollars are slightly harder to measure because the markets are liquid.
Quick Reminder: The Difference Between ESG and Impact Investing
The commonly accepted definition of Impact investing is the allocation of financial capital towards companies, organizations and funds with the intent of generating social and environmental impact alongside financial return.
ESG investing, as described by Gitterman Wealth Management: “…encompasses investment methodologies that embrace environmental, social, governance or sustainability factors as a means of helping to identify companies with superior investment models. These environmental, social and governance factors are thought to provide asset managers with additional insight into the quality of a company’s management, culture, risk profile, as well as other characteristics.”
There are two main hypotheses surrounding ESG and Impact investments.
· Hypothesis 1: ESG investments are harder to quantify, as compared to Impact investments.
· Hypothesis 2: Over the long-term, the outcomes of ESG investing are often more advantageous than that of Impact investing, because ESG investments change the company from within.
“We believe that an economically efficient, sustainable global financial system is a necessity for long-term value creation. Such a system will reward long-term, responsible investment and benefit the environment and society as a whole.” – The United Nations Principles for Responsible Investment (UN-PRI)
Impact is Difficult to Measure
The UN-PRI, the world’s leader in responsible investment and the global entity seeking to encourage investment leaders to sign the six principles of responsible investing (see appendix for description of all six principles), further defines impact as: “the proportion of the total observed outcome that can be attributed to a company’s activity, above and beyond what would have happened anyway.” The reason impact is difficult to measure is that it is hard to prove that an allocation of capital towards a company is directly related to an observed outcome. For example, proving that improved employee happiness is a direct result of investment dollars is an arduous task.
Consequently, “It is more common to track outputs and outcomes, using indicators that imply rather than prove impact.” – UN-PRI. Outputs are defined by the UN-PRI as the measurable results occurring from a company’s activities, while outcomes are defined as the intended and unintended changes in a system that result from aforementioned outputs.
Principle 3 of the Six Principles of Responsible Investing mandates signatories to demand transparency regarding ESG issues pertaining to the entities the signatories choose to invest in. The UN-PRI suggests means for investors to adhere to Principle 3. Possible actions, as proclaimed on the UN-PRI website, include: asking for ESG issues to be integrated in, and reported on, in annual or biannual financial reports, asking for standardized ESG reporting from companies (using tools such as the Global Reporting Initiative) and supporting and encouraging shareholder initiatives that promote disclosure of ESG issues. Investors and shareholders can, and should, ask for additional information about a company’s adherence to relevant codes of conduct or other renowned standards, such as the UN Global Compact.
In this way, investors who are signatories of the UN-PRI have tools in place and a responsibility to measure the impact of their ESG investments. When selecting ESG investment managers to invest with, it may be wise to choose asset managers that are signatories of the UN-PRI.
In conclusion, measurement is paramount in order to understand risk.
Many data providers offer ESG scores or factors for investment securities. Using this methodology across an investment portfolio aggregates a handful of ESG scores together. However, even though such databases exist, ESG metrics can be rather subjective, as “high impact” to one investor might not necessarily mean “high impact” to the next.
An investor must, therefore, consider and reflect upon which ESG factors are most important, taking into consideration his/her risk tolerance, desired impact, diversification needs and target return. A wealth manager that has expertise in ESG investing, such as Gitterman Wealth Management, can assist with this, as such wealth managers are astute in understanding ESG factors and, importantly, analyzing those factors in the greater context of your investment portfolio.
ESG factors are rigorously integrated into public market investment portfolios in many different ways. For example, active ESG portfolio managers typically embed the consideration of environmental, social and governance factors into their fundamental investment selection process, while passive ESG asset managers are looking for “financially immaterial ways to integrate ESG factors” (Goldman Sachs Asset Management).
Goldman Sachs Asset Management (GSAM) further postulates three chief ways that investors can measure the value of any given ESG metric:
- Investors can compare their ESG scores to peers that are managing similar portfolios.
- Investors can compare their ESG scores to a common benchmark.
- Investors can compare their ESG scores to their previous investment history.
You might be thinking that the three aforementioned ways of measuring relative ESG impact are very similar to that of traditional investment management. They are. This should make sense because ESG investing is, in fact, just a more thorough method of conventional investment management. The investment selection process is very similar to that of a conventional investment selection process, with the exception being an increased attentiveness to ESG factors that are likely to affect a company’s long-term performance. In fact, one could say ESG investing is just traditional investment management with more rigorous due diligence.
Appendix: (Quoted directly from UN-PRI website)
“As institutional investors, we have a duty to act in the best long-term interests of our beneficiaries. In this fiduciary role, we believe that environmental, social, and corporate governance (ESG) issues can affect the performance of investment portfolios (to varying degrees across companies, sectors, regions, asset classes and through time). We also recognize that applying these Principles may better align investors with broader objectives of society. Therefore, where consistent with our fiduciary responsibilities, we commit to the following:
Principle 1: We will incorporate ESG issues into investment analysis and decision-making processes.
Principle 2: We will be active owners and incorporate ESG issues into our ownership policies and practices.
Principle 3: We will seek appropriate disclosure on ESG issues by the entities in which we invest.
Principle 4: We will promote acceptance and implementation of the Principles within the investment industry.
Principle 5: We will work together to enhance our effectiveness in implementing the Principles.
Principle 6: We will each report on our activities and progress towards implementing the Principles.”